Allen Products, Inc., wants to do a scenario analysis for the coming year. The pessimistic prediction for sales is $900,000; the most likely amount of sales is $1,125,000; and the optimistic prediction is $1,280,000. Allen's income statement for the most recent year follows.
Allen Products, Inc. Income Statement for the Year Ended December 31, 2012
Sales revenue .................. $937,500
Less: Cost of goods sold ............. 421,875
Gross profits ................. $515,625
Less: Operating expenses ............ 234,375
Operating profits ................ $281,250
Less: Interest expense .............. 30,000
Net profits before taxes .............. $251,250
Less: Taxes (rate = 25%) ............ 62,813
Net profits after taxes .............. $188,437
a. Use the percent-of-sales method, the income statement for December 31, 2012, and the sales revenue estimates to develop pessimistic, most likely, and optimistic pro forma income statements for the coming year.
b. Explain how the percent-of-sales method could result in an overstatement of profits for the pessimistic case and an understatement of profits for the most likely and optimistic cases.
c. Restate the pro forma income statements prepared in part a to incorporate the following assumptions about the 2012 costs:
$250,000 of the cost of goods sold is fixed; the rest is variable.
$180,000 of the operating expenses is fixed; the rest is variable.
All of the interest expense is fixed.
d. Compare your findings in part c to your findings in part a. Do your observations confirm your explanation in part b?